Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Shanghai Moons' Electric Co., Ltd. (SHSE:603728) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shanghai Moons' Electric's Net Debt?

The image below, which you can click on for greater detail, shows that Shanghai Moons' Electric had debt of CN¥262.7m at the end of March 2024, a reduction from CN¥328.9m over a year. But on the other hand it also has CN¥569.5m in cash, leading to a CN¥306.8m net cash position.

A Look At Shanghai Moons' Electric's Liabilities

We can see from the most recent balance sheet that Shanghai Moons' Electric had liabilities of CN¥890.2m falling due within a year, and liabilities of CN¥93.4m due beyond that. Offsetting this, it had CN¥569.5m in cash and CN¥860.7m in receivables that were due within 12 months. So it actually has CN¥446.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Shanghai Moons' Electric could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shanghai Moons' Electric has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Shanghai Moons' Electric if management cannot prevent a repeat of the 50% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Moons' Electric's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Shanghai Moons' Electric has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Shanghai Moons' Electric saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Moons' Electric has CN¥306.8m in net cash and a decent-looking balance sheet. So although we see some areas for improvement, we're not too worried about Shanghai Moons' Electric's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Shanghai Moons' Electric you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.